An innovation in financial markets is the development and use of industry losses from catastrophic (CAT) events, such as hurricanes and earthquakes, as a trigger mechanism for payout of a specified amount of money to an insurance company or other insured entity. This trigger mechanism offers a potentially more cost-efficient mechanism for financing CAT losses than conventional insurance and reinsurance. Index-Linked Securities (“ILS”) can be issued in various forms, including securities (e.g., CAT bonds), derivatives, or reinsurance. Insurers can use these instruments to hedge or reinsure their exposure to CAT losses. It is noted that throughout this description when the term “security” or “securities” is used it refers to the ILS instruments which may or may not be a security as that term is defined by law.
However, such instruments may not always pay an amount that equals the insured's (or reinsured's) actual loss. In the case where the instrument does not sufficiently compensate an insured (or reinsured) for its actual losses from a CAT event, this shortfall is referred to as negative basis risk. In another case where the instrument overcompensates an insured (or reinsured) relative to its actual losses from a CAT event, this overage is referred to as positive basis risk.
The reduction of basis risk is a key goal of those designing ILS instruments because the more basis risk is reduced, the more cost effective and appealing ILS instruments are as an alternative to standard reinsurance that reimburses insureds for losses on a basis directly linked to the insured's (or reinsured's) actual losses.
The index can be any of a number of commonly used industry indexes that record the industry loss of certain meteorological or seismic parameters related to a natural disaster event. However, for insurers to effectively use the hedging potential of these types of security instruments, the insurers must understand this basis risk with respect to their portfolio. Thus, an advantageous tool would present data concerning such basis risk to the potential purchaser of these types of securities. Moreover, the finer the granularity of this understanding, the more useful the tool may be to the potential buyer.